To many times I come across clients who either have income protection policies established on an indemnity basis or established as agreed value without financial evidence being supplied to the insurer to financially endorse the contract.
Whilst income protection cover held via a self managed super fund is generally not a highly implemented strategy for SMSF trustees, I find invariably SMSF trustees are business owners or are in professional or executive roles where there is a variable nature to their personal exertion income. Whether the cover is structured inside or outside super, as the role of insurance is to provide certainty to the insured should the worst occur, I am amazed to find that only around 30% of income protection policies are financially endorsed.
There are 3 ways you can establish your income via an income protection contract:
- Indemnity – this is where you set the sum insured on the understanding that your income will be assessed for the 12 month period leading up to claim (or best 12 months in the 3 years preceding on some policies).
- Agreed Value – this is where you set the sum insured based on your current income. In the event of a claim the income for the 12 months prior to implementing the policy would need to be provided to support the benefit.
- Endorsed Agreed Value (or Guaranteed) – this is where you provide financial evidence to the insurer at the time of application to support the benefit being applied for. Once endorsed no financial evidence will be required in the event of a total disability.
Whilst the attractiveness of implementing indemnity cover is the premium is approximately 15% cheaper, and there is minimal effort to implement the cover without providing financial evidence, the significant downside is it does not provide certainty to the life insured as to the benefit to be received in the event of a claim. The uncertainty comes about for the following reasons:
- The financial documents required to substantiate the required income period may not be available at the time of claim.
- The client and in some cases the adviser do not understand the insurers definition of insurable income.
- The client and in some cases the adviser note a self employed person’s revenue as income instead of making the distinction between income and ongoing expenses. i.e. the difference between the need for income protection cover versus business expense cover.
- If there is potential for varying levels of income having income assessed for the period prior to claim could result in assessing the insured’s income at the worst period of time.
- The benefit will be capped at 75% of the pre-disability earnings. Therefore the insured could be paying significant premiums which they may not receive a benefit from.
- There are sources of ongoing (or passive) business income which the insurer may offset in the event of a claim or should have considered at the time of application.
Consider the following examples:
Example 1:
John is a self employed marketing consultant and seeks advice for income protection cover. John is asked his income to which he reply’s “my income is $160,000 per annum”. As such is income protection benefit is calculated at $10,000 per month (75% of $160,000 per annum) and cover is implemented on an agreed value basis but financial evidence is not provided to support the application. 2 years later John has an accident and is unable to work. As required financials are supplied for the 12 months leading up to application which shows his income as:
Gross Income (revenue): $160,000
Rent: $25,000
Staff Wages: $20,000
Staff Super: $1,800
Utilities (phone etc): $5,000
Stationary/Office Expenses: $5,000
Total (expenses) $56,800
Net Income (Insurable Income) $103,200
Based on this insurable income above, the benefit payment would be restricted to $6,450 per month meaning John has been paying a premium for an additional $3,550 per month of cover he will not get a benefit from.
Example 2:
Pharmacy proprietors are in the unique position that should they suffer a disability and be unable to work, their income and profit will continue provided the remaining employed pharmacists or an additional pharmacist can be sourced to continue running the business. Employing the additional pharmacist or increased wages can cost up to $100,000 per annum in additional expenses, which essentially comes off their bottom line or is the structured salary they may otherwise pay themselves. However, despite this loss of income they will most likely still generate ongoing profit (albeit reduced). It is this ongoing profit or income stream which creates a challenge when obtaining appropriate income protection insurance as our research has found that insurers deal with this issue in one of the following ways:
- Most policies will have an ongoing income offset clause built into the policy wording.
- At the point of application the underwriter assessing the case will apply this offset clause as a special condition on the policy.
- Depending on the level of ongoing income, income protection cover may be declined outright.
If financial endorsement is not done upfront again benefits may be reduced leading to dispute between the life insured, the insurer, the life adviser and accountant over the benefit being paid versus the benefit expected to be paid. This issue also applies to other professional businesses such as accounting and legal firms.
The last thing you should go through in the event of a disability is a dispute over the benefit you are to receive. As such, if you hold an existing income protection policy ask yourself the following questions:
- Has my cover not been financially endorsed?
- Is there uncertainty of the benefit my policy will provide me in the event of a total or partial disablement?
- Does my income have the potential to vary year to year or is reliant upon my business performance?
- Does my business have the potential to provide me an ongoing income stream if I am not working in it?
If you answered yes or are unsure to any of the above, get the appropriate advice.
